The Nuts and Bolts of How Hedge Funds Work

You may have heard a lot about hedge funds on television and perhaps, in newspapers.

What exactly is a hedge fund, and what do they do?

Hedge funds have been in existence for several decades since the launch of the very first ever fund in 1949 by A.W Jones & Co. Since then, their popularity has soared, and today there are more than 10,000 hedge funds.

Break it down: what is a hedge fund?

A hedge fund is essentially a group of people who come together to invest in the market. They raise money or provide the initial funds themselves and hope to make a killing in the market. Eventually, they open the hedge fund to others who wish to invest and participate in the profits.

Similar to mutual funds, hedge funds invest in many types of securities such as bonds, stocks, and commodities. However, investment techniques associated with hedge funds are more sophisticated and risky. Hedge funds allow investors to gain exposure to more exotic financial instruments, like derivatives and options.

And boy, are they popular! Hedge funds being managed globally, are estimated to have a combined value of around $3 trillion. Despite being around for a long time, hedge funds operate with little or no regulation from the SEC – the Securities and Exchange Commission – which is mandated to supervise the activities of such investments.

How do hedge funds work?

The goal of a hedge fund is to minimize risk in an unpredictable financial environment. While that seems to be a significant factor driving the establishment of hedge funds, the goal of maximizing profit is probably important too.

Remember a hedge fund works by pooling funds together for investment purposes. This pooling of funds allows a hedge fund manager to make tons of money by leveraging other people’s money.

Let’s assume that a company called Tiny Pony Investments runs a hedge fund, allowing it to invest anywhere in the world. In Tiny Pony’s operating agreement, the company indicates that it will receive a 20% cut on profits over 5%.

Now, five investors who are keen on investing in Tiny Pony Investments decide to sign up, each of them investing 20 million each. Tiny Pony starts out with $100 million in its basket of funds. After a year of activity let’s say Tiny Pony makes $50 million, giving it $150 million in total assets under management.

Per the fund agreement, the five original investors are to benefit from 5% of the 150 million – also known as the hurdle rate. And the remaining amount is split 80-20 between the investors and the firm. With this agreement in place, the firm takes $28 million of the remaining $142 million (after the 5% haircut). Many hedge funds work this way, while others implement slightly different structures.

Hedge funds typically employ the use of long-short strategies to meet their objective of profiting in risky environments. A long strategy simply means you are betting for the price to go up and a short strategy means you expect the price to fall and you position yourself appropriately. So if you ran a hedge fund, you might buy 100 shares of Google (long) and short 20 shares of Apple such that the dollar amounts of each of your bets are equal. Ideally, you want Google to appreciate and Apple to take a dive.

Other things you should know

Hedge funds are not for everybody. Investors who prefer to hedge are required to have a net worth of not less than $1 million. Make sure you count your bank notes before investing in a hedge fund!

Hedge funds are not restricted in any form of investments. You can simply invest in anything, from real estate to currencies, unlike mutual funds which have limited investment opportunities. Mutual funds can only invest in stocks or bonds.

Hedge funds can take advantage of leverage. What this means is that you can use borrowed funds to increase your Keep in mind that this comes at a huge risk.

Many hedge funds charge an expense ratio, and performance fee typically referred to “Two and Twenty” which translates as a 2% asset management fee and then 20% cut on all gains. This is a controversial operating scheme because the manager makes money even if the fund loses money in a given year. The manager is guaranteed that 2% fee in all cases.

Buyer beware

Most hedge funds fail to beat the market.

There are just a few that consistently outperform. The ones that do attract more assets and become even more insulated from the regular investor than the average hedge fund – already very isolated.

Most famously, Warren Buffet bet the asset manager of Protégé Partners that he could outperform a basket of hedge funds by merely investing in a simple ETF. Over a nine-year period, the bundle of hedge funds returned just 2.2% annually, compared with 7.1% for Buffett’s index fund.

The reason hedge funds fight an uphill battle is similar to why mutual funds fail to the beat the market. Fees just eat away at the gains. In the context of Buffett’s bet, the billionaire estimated that as much as 60% of the returns produced by the basket of hedge funds were destroyed through fees.

The Bottom Line

Hedge funds serve a need, just not for your average investor. Hedge funds like Soros Management or Bridgewater Capital are famous for returning 20% year after year but how many people get to participate in that?